Bank Financial Reporting - 'The Cause Is Hidden, But The Result Is Well Known'

Are you the trusting sort? How about when it comes to trusting banks some six years after the financial crisis? You should consider reading The Atlantic’' recent article "What's Inside America's Banks?" on why many in the investment world, and the general public, still don't trust banks.

In this article, the authors give reasons such as 1) the highly publicized fallout from the JPMorgan chief investment officer's $6 billion trading position loss, 2) big banks' manipulation of LIBOR, 3) the accusation that U.S. government officials helped Mexican drug dealers launder money, and 4) the charge that American banks falsified mortgage records by "robo-signing" papers to speed up the foreclosure process. Not pretty stuff when it comes to restoring trust in banks.

What about trusting bank financial reporting? The authors go through some key financial reporting matters of a supposedly conservative bank to demonstrate how the opacity of the financial disclosures in its annual report leaves users (i.e., investors) in the dark about its financial performance. To give you an idea, here is a passage from Wells Fargo's 2011 annual report (the most recent one available) as cited in the article, which defines the $1 billion earned from its "customer accommodation" trading in this manner: "Customer accommodation trading consists of security or derivative transactions conducted in an effort to help customers manage their market risk and are done on their behalf or driven by their investment needs."

The authors further describe Wells Fargo's disclosures of the risks associated with its customer accommodation trading and other free-standing derivatives. The article highlights one of the problems with understanding a large bank's financial position, namely that the banks are as complex and opaque as ever since before the crash despite sizable efforts to reform the system. The authors point out that bank disclosures range from light and airy to dense and incomprehensible.

Even the head of investor relations at Goldman Sachs says in the article that average people don't understand banks because there is a lack of transparency. Sophisticated investors have a better understanding, but the fact that ordinary people have trouble contributes to a loss of faith in banks. What is even more telling is that even those with considerable expertise and knowledge of accounting practices and financial reporting don't trust the banks. The authors asked two former board members of the U.S. Financial Accounting Standards Board (FASB) whether they trusted the accounting by banks. Both said "no."

Finally, Paul Singer, head of Elliott Management, recently stated in an exchange with JPMorgan's Jamie Dimon at the 2013 World Economic Forum that the global banks are "too opaque." As reported in the Financial Times, Singer said that the unfathomable nature of banks' public accounts made it impossible to know which were "actually risky or sound."

Improvement in disclosures of risks is one area where investors would clearly benefit. CFA Institute recently issued a report titled "User Perspective on Financial Instrument Risk Disclosures Under IFRS (Volume 2)" that focuses on the disclosures of derivatives and hedging activities of financial and non-financial institutions.This report will help to inform both the International Accounting Standards Board (IASB) and FASB as they seek to improve derivatives disclosures. The recommendations cited in the report, which focus on the needs of investors, will help to further restore trust in banks by shedding light on risks.

As the title to this article (a line translated from Ovid's Metamorphoses) suggests, investors know what happened, they just don't always know why. Better disclosure will help to restore trust.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.